The reason you went into business selling services to customers was to make a profit. If you were giving away your services for less than cost, or just breaking even, you'd be operating a non-profit venture – or a business that's likely to fail. There are a variety of components that factor into whether or not a business is profitable, including location, leadership, market demand, competition, and so on. But one of the most important decisions you need to make to determine whether you turn a profit or not is how to price your services.
Service businesses can range from a sole proprietorship consultancy to mid-sized businesses with several hundred employees, some of whom go out to customers and perform anything from cleaning homes to providing information technology expertise to large corporations. Get your pricing strategy for these services wrong and you will create a problem you may never overcome. Get it right and you will dramatically increase the likelihood of creating a business that perseveres and takes care of you financially.
"It can just destroy you if you don't do it right," says Charles Toftoy, an associate professor at the George Washington University School of Business and Public Management. Toftoy has helped counsel 1,500 small businesses along with his graduate students. "It doesn't matter whether you're putting out a novel you've written or providing a service through a pest control company or you're a veterinarian. The bottom line is that pricing is extraordinarily important."
The following pages will provide a guide to how to price your services, the benefits and risks of certain pricing structures, and how to monitor and change the pricing for your services without alienating customers.
Pricing Your Services
The good news is you have a great deal of flexibility in how you set your prices. The bad news is there is no surefire, formula-based approach you can pull off the shelf and apply in your business. Pricing services is more difficult than pricing products because you can often pinpoint the cost of making a physical product but it's more subjective to calculate the worth of your counsel, your staff's expertise, and the value of your time. You can, however, use some of the same underlying pricing guidelines to figure out your costs and operating expenses plus your target profit in setting your price for services.
Factors to consider in pricing
When pricing services, there is a bit more leeway than pricing products. "The price of a product is more objective. The price of a service is more subjective so that there is a gray area," Toftoy says. "Pricing is both an art and a science." Here are the factors that experts say you should consider when trying to determine what price to charge for a service:
- Cost-plus pricing. This standard method of pricing in business seeks to first determine the cost of making a product or, in this case, providing a service, and then add an additional amount to represent the desired profit. To determine cost, you need to figure out direct costs, indirect costs, and fixed costs. "With the cost-plus approach, the thing to remember is that if you're paying someone $11 an hour, you may think you should charge $11 an hour for the service they provide, but you have to factor in all your costs," says Jerome Osteryoung, a professor of Finance at Florida State University and outreach director of the Jim Moran Institute for Global Entrepreneurship. Those costs include a portion of your rent, utilities, administrative costs, and other general overhead costs. "When I make a deal to sell a service," he says, "I have to make sure to cover all my costs."
- Competitors' pricing. You need to be aware of what competitors are charging for similar services in the marketplace, Osteryoung says. This information could come from competitor websites, phone calls, talking to friends and associates who have used a competitor's services, published data, etc. "I don't think it's a good idea for any entrepreneur to compete on price if you can avoid it. Compete on service, ambiance, or other factors that set you apart," Osteryoung says. If you have to compete on price to win a customer, you may ask yourself whether that customer will be loyal to you if they find someone offering a service at a lower price. You want to establish long-term relationships in the marketplace. "You need to convince the customer that you are giving them tremendous value in terms of service and quality," Osteryoung says. "You just need to be aware of what the competition is charging."
- Perceived value to the customer. This is where a lot of the subjectivity comes in when setting a price for a service. When you have a product, you may decide to use keystone pricing, which generally takes the wholesale cost and doubles it to come up with a price to charge and account for your profit. With a service, you can't necessarily do that. To your customer, the important factor in determining how much they are willing to pay for a service may not be how much time you spent providing the service, but ultimately what the perceived value of that service and your expertise is to them, Osteryoung says. That is where pricing becomes more of an art form.
Calculating your costs
Before you set a price for the services your company will provide, you need to understand your costs of providing these services to customers. The U.S. Small Business Administration advises that the cost of producing any service is made up of the following three parts:
- Materials cost. These are the costs of goods you use in providing the service. A cleaning business would need to factor in costs of paper towels, cleaning solutions, rubber gloves, etc. An auto repair business would tally up the cost of supplies, such as brake pads or spark plug, which are being installed by service people. You may want to include the material list with your estimate in bidding for a job.
- Labor cost. This is the cost of direct labor you hire to provide a service. This would be the hourly wages of your cleaning crew and/or a portion of your mechanic's salary and benefits while they were providing the service for your customer. The SBA recommends using a time card and clock to keep tabs on the number of hours of labor involved in providing each service for a customer.
- Overhead costs. These are the indirect costs to your business in providing services to customers. Examples include labor for other people who run the firm, whether administrative assistants or human resources personnel. Other overhead costs include your monthly rent, taxes, insurance, depreciation, advertising, office supplies, utilities, mileage, etc. The SBA suggests that a reasonable amount of these overhead costs should be billed to each service performed, whether in an hourly rate or a percentage. One important thing to note: don't just depend on figures from last year to determine your overhead costs. You need to charge customers rates that cover your current costs, including higher salaries to employees, inflation, etc.
Determining a fair profit margin
Once you determine your costs, you need to mark up your services to ensure that you achieve a profit for your business. This is a delicate balance. You want to ensure that you achieve a desirable profit margin, but at the same time, particularly in a down economy, you want to make sure that your business doesn't get a reputation for overcharging for services. Osteryoung suggests that you look for resources in your industry, such as the annual statement studies on small and mid-sized business financial benchmarks from Risk Management Associates, to help you determine whether your profit margin is on target. "The net profit margin for a specific industry might be 5 percent, so if I'm sitting on 2 percent I need to come up a bit," Osteryoung says. "I need to sell services, give value, and make sure the firm runs a fair rate of return."
Different Pricing Models
Now that you understand what it costs you to provide a service, what your competitors are charging, and how customers perceive the value of your services, it's time to figure out whether to charge an hourly rate, a per-project rate, or try to negotiate a retainer for your services. This may be predetermined by your industry and the type of service pricing that predominates in your sector. For example, lawyers tend to charge hourly rates for their services, although those rates can vary. Many construction firms charge a project fee and require that one third be paid up front, another third be paid at the half-way point, and the remaining third be paid upon completion.
Here are some benefits and risks associated with the following pricing models:
- Charging an hourly rate. For many businesses, pricing services on an hourly rate is preferred. This ensures that you are achieving a rate of return on the actual time and labor you invest in servicing each customer. Hourly rates are often used when you are pricing your own consulting services, instead of pricing a service that uses labor and materials from others. Your rate should be determined by your amount of expertise and seniority; a more senior consultant will generally be paid a higher hourly rate than a less experienced or junior consultant. The SBA recommends that one's travel time be included as an extra charge. Sometimes even consultants are asked to price a service on a project or contract basis. That contract needs to factor in clerical support, computer or other services, and overhead expenses, the SBA advices.
- Charging a flat fee. In tough economic times, many businesses are concerned about keeping costs down and may agree to hire your business for services only on a fixed-rate or flat-fee basis. "Customers want a fixed rate," Osteryoung says. "Entrepreneurs want an hourly rate. It's a question of who is going to bear the risk. If I charge a flat rate, I am bearing the risk." If a project takes longer than expected to complete, you may risk losing money on the client. If you have a customer that insists on a flat fee, you may want to see if they are amenable to putting a cap on the number of hours involved in the project or agree to pay additional fees if the project runs over that time.
- Variable pricing. In addition to determining a fair price for your services, you have to determine whether you will practice a fixed-price policy and charge all your customers the same amount or whether you want to institute variable pricing, in which bargaining and negotiation help set the price for each customer. "Should you charge different customers different rates? I have a hard time with that," Osteryoung says. "The exception is if someone comes in and says that they will book 1,000 hours of time, you may want to give them a price break for quantity. But in general, charging different prices to different customers will create ill will. People will talk about it and they will find out." One thing a business can not afford to lose is its integrity and respect among customers.
Monitoring and Changing Your Price
In a service business, your biggest costs are usually your people costs -- salaries, benefits, etc. If you are having a hard time selling services at an acceptable profit, the problem may be that your employee costs are too high rather than the price is too low. You may want to also re-evaluate your overhead costs to determine whether there are other cuts you can make to bring your price down and your profit margin up. "Look at your expenses and see where you can cut," Toftoy advises.
Monitor profitability monthly
You need to understand the profitability of your company every month. By the 15th of every month, you ought to have your financial statements from the previous month. "If there is any mistake I see entrepreneurs make, it's that they don't spend enough time going over their financial statements," Osteryoung says. "In some cases, no one has ever shown them how to do that. I see their eyes glaze over." In addition to understanding your monthly profitability, you need to understand the profitability (or lack of profitability) of every service you sell. Make absolutely sure you know the degree to which every person or project you sell is contributing to your goal of making money each month.
Test the market for new services and prices
You should always be testing new prices, new offers, and new combinations of benefits and premiums to help you sell more of your services at a better and better price. Often the perfect time to do this is when quoting a price to a new customer. Raise the price and offer a new and unique bonus or special service for the customer. Measure the increase or decrease in the volume of services you sell and the total gross profit dollars you generate.
Be wise about raising your prices
It's a fact of life that you will have to raise prices from time to time as part of managing your business prudently. If you never raise your prices, you won't in business for long. You have to constantly monitor your price and your costs so that you are both competitive in the market and that you make the kind of money you deserve to make in your business. But there are risks to raising prices, particularly when your customers are going through tough financial times.
"You can price too high and sell yourself out," Toftoy says. "People don't forget that they felt like you gouged them for the quality of the service you were selling."
Here are some guidelines for when and how to raise prices:
- Do raise prices when your competitors are raising prices. If the competition has upped the ante, that is a good signal that the market can and will support a price increase for your services, too.
- Do raise prices if your customers say you're a bargain. If your customers start commenting about what a great value your services are, that "may be an indication you're charging too low a price," Osteryoung says.
- Don't raise prices too much all at once. In a tough economy, a big jump in prices might be too much of a jolt for your customers. Instead, raise prices in small increments of two or three price increases over the course of a year, Osteryoung suggests.
- Don't raise prices across the board. Do be discreet. Customers may not notice price increases if they are only for certain services and not for others. Osteryoung recalls speaking with a dentist who recently raised prices on fillings but not cleanings -- a strategy that brought no customer complaints. "You need to raise prices in today's economy where you think your customer can't see there has been an increase," he says.
The bottom line is: You owe it to yourself and to your business to be relentless in managing your pricing strategy. Remember, how you set the price of the services you sell could be the difference between the success -- or failure -- of your business.
The Price Is Right Setting prices has always been more art than science. New software aims to change that.
The Right Price
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Is It Time to Raise Prices?
Boost your bottom line by taking the guesswork out of pricing.
Flexing Your Pricing Muscles
Despite years of almost no inflation, you may have more pricing power than you think. Here's how to exercise it without bruising yourself in the process.
This page has some of the best business books and audio programs you can read. Most are focused on improving profitability and cash flow.
How to Sell at Margins Higher than Your Competitors: Winning Every Sale at Full Price
by Lawrence L. Steinmetz, and William T. Brooks
This is book discusses the importance of margins in setting prices. It is available at any online or traditional bookstore. The authors also conduct do seminars and have audio programs on the subject of selling at higher margins.
The Art of Pricing: How to Find Hidden Profits to Grow Your Business
By Rafi Mohammed
The author has a very interesting point about how to get out of the pricing 'Catch 22' by adopting a multi-price mindset.
SurvivalWare is a software tool that shines the light on your cash flow and profitability. Everything you do in setting prices must be measured by the degree to which it helps you make money and create cash flow. It is powerful, yet easy-to-use.
U.S. Small Business Administration's "Pricing Your Products and Services Profitably
This guide discusses how to price your products profitably, plus various pricing techniques and when to use them.
Risk Management Association's Annual Statement Studies
One of the few sources of benchmarking data from the financial statements of small and mid-sized businesses that are customers of RMA. Broken down by industry, this data can be used to help you set prices for your services.